Long-term Plan Will Overcome Wild Short-term Swings

Fund Watch HUMBERTO CRUZ

February 19, 1997|HUMBERTO CRUZ

Q: I read your articles about saving for retirement and have a question. If the amount you need to save is based on the assumption that your money is growing at a 6 percent rate after inflation, what do you do if you fail to achieve that rate of return?

A: The flippant answer is that you then have to save more money. But the thoughtful response is that you've asked a very important question that quite often is not addressed adequately in most stories about retirement planning.

Let's say you need to save $300 a month over the next 10 years to have enough to retire. That's based on the assumption that your current investments, as well as the $300 you'll be adding every month, will grow at an average rate of 6 percent a year after inflation.

You could reasonably expect that kind of long-term return from a diversified portfolio of high-quality stocks. But what happens if there is a market drop and your stocks fall 20 percent the first year?

I put the question to Gaylon E. Greer, a professor of finance at the University of Memphis. Greer ran a seminar on retirement planning in Palm Beach and has been my main source in previous columns on the subject.

"If you have nerves of steel," Greer said, you don't have to do anything. "For long-term planning, we can rely on long-term averages," he said, meaning future gains are likely to make up for the initial decline.

But the fact is, few of us would remain calm after seeing the value of our retirement savings drop 20 percent. Greer said a solution is to increase savings a bit the second year - and maybe the third and fourth - to make up for the loss. But nothing dramatic, he said.

And, as retirement day approaches, we should recheck our calculations to make sure we are still on track, he said.

Now for the other side of the coin, which you didn't ask.

If our money makes more than 6 percent at first, we can either save less in the future, take lower risks or both.

People usually say they want the highest possible return with the lowest possible risk.

The best definition of "highest possible return" I've heard came at the annual Money Show seminar at Disney World this month:

Highest possible return is "the return you need to be able to go where you are trying to go," said Paul Merriman, a Seattle investment adviser.

If you have been investing mostly in stocks for the past two years, for example, your return is likely to have been far in excess of 6 percent a year after inflation.

You may need to make only 5 percent a year or less from now on.

So if that is all you need, why take more risks than necessary? Being ahead of the game, of course, you may instead decide to come up with a more ambitious goal. It's up to you, but the important thing is to know where you stand.

Q: You wrote a column about a couple saving for their child by contributing $2,000 to the child's individual retirement account. According to my accountant, the scheme you describe does not work because the funds gifted to the child are not earned income. Comments?

A: Yes, you did not read my column carefully enough.

I said a parent can always give a son or daughter up to $2,000 a year to put in an IRA as long as the child has earned that much from work that year.

The main point is that a child is sometimes hard-pressed to save enough to come up with the money for an IRA contribution. He or she may work summers saving for college, make the $2,000 or more, and then spend all of it in tuition and fees or other living expenses.

It's perfectly legal in this case for the parent to give the child $2,000 as a gift to put into the child's IRA.

The child would likely get a tax break, and the $2,000 is not enough to trigger a gift-tax liability for the parent.

And it's a gift that will keep on giving as the money grows over time.

You can give your children the money for the IRAs now and tell them that's their inheritance.